The Tax Consequences of Fee-for-Service (Part 1 of 2): The Exempt Purpose Test

The past decade has been marked by the increasing commercialization of the non-profit sector. Faced with cutbacks in government funding and foundation grants, as well as dwindling private donations in the wake of the 2008 recession, non-profit organizations have looked to other sources of revenue to make up the difference. These factors, combined with the influence of the “social entrepreneurship” movement, have led non-profits to seek innovative models of philanthropy that increasingly resemble commercial enterprises.

“Fee-for-service” (an informal term of art the non-profit community uses to describe revenue non-profits generate from the sale of goods or services) has thus become an important and perhaps necessary source of revenue for a growing number of non-profit organizations. Fee-for-service revenue is attractive as a diverse and potentially more reliable source of revenue than grants or donations. Importantly, fee-for-service revenue is also a source of “unrestricted funds,” which can fund crucial overheard expenses without limitation. However, for all of these attractive qualities, the fee-for-service model implicates tricky tax issues, which must be carefully considered before launching any fee-for-service activities.

This article, the first in a two-part series, provides a brief overview of one of the main tax issues arising from the fee-for-service model: the exempt purpose test. Specifically, this article examines when fee-for-service activities may be inconsistent with the missions of organizations exempt under section 501(c)(3) of the Internal Revenue Code (the “Code”). Part Two will discuss the basic rules for determining whether a fee-for-service activity triggers unrelated business income tax (“UBIT”).

The exempt purpose test seeks to ensure that a tax-exempt organization does not stray too far from the mission our tax laws deem worthy of favored tax status. To qualify for tax-exempt status under section 501(c)(3) of the Code, an organization must be operated primarily in furtherance of one or more of the “exempt purposes” recognized under section 501(c)(3) of the Code, for example: charity, education, promotion of health, promotion of the arts, advancement of science, and advancement of religion. Activities that do not further an exempt purpose must be insubstantial. An organization may operate a trade or business as a substantial part of its activities, so long as the operation of such trade or business furthers an exempt purpose and the organization is not operated for the primary purpose of carrying on an “unrelated trade or business” (the definition of an “unrelated trade or business” is discussed further in Part Two).

Application of these rules has proven exceedingly difficult. There is no definition of “substantial” or “insubstantial,” and no clear way of determining whether a trade or business furthers an exempt purpose. In practice, the Internal Revenue Service and the courts have relied largely on a much-criticized body of law called the “commerciality doctrine” to determine whether an organization’s fee-for-service activities are consistent with 501(c)(3) status. In essence, the commerciality doctrine states that organizations that too closely resemble comparable for-profit businesses are not worthy of 501(c)(3) status. The commerciality doctrine has been very arbitrarily and unevenly applied: one can think of innumerable examples of tax-exempt hospitals, universities, and publishers whose operations are indistinguishable from their taxable, for-profit counterparts. However, some guidance can be gleaned from illustrative cases.

A good example is Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991), which involved an organization formed to promote the tenets of the Seventh Day Adventist Church, one of which is vegetarianism and healthy eating. The organization’s purpose was ostensibly religious, but the organization’s main activities were the operation of two vegetarian restaurants/health food stores. The stores charged prices that were the same as for-profit competitors in the area. Adventist literature was displayed throughout the stores, and cooking classes and bible study classes were held after business hours. Additionally, the organization held a devotional talk and hymn singing every morning before opening. The organization relied entirely on income from the stores and had no plans to solicit donations.

The Seventh Circuit relied on the commerciality doctrine in holding that the organization was operated substantially for a non-exempt purpose and did not qualify for exemption. While some of the organization’s activities clearly furthered a religious purpose (display of Adventist literature, bible study classes, devotional talks, and hymn singing), the court ruled that these activities were secondary to the store’s commercial operations. The court noted that the organization was run just like a commercial business, e.g. with regular business hours and promotion through advertising. The court also emphasized that the organization competed with similar for-profit businesses, set prices at market rates, and had no revenue from any other sources.

Based on Living Faith, Inc. and similar cases, 501(c)(3) organizations engaging in commercial activities can take several precautionary measures. First, it is important for an organization to engage in a significant amount of activities that are clearly within the traditional notions of a 501(c)(3) organization. The organization should use revenue from its fee-for-service programs to fund these traditional 501(c)(3) activities, and must take steps to demonstrate these activities are an important priority rather than an afterthought. Second, an organization would be wise to differentiate itself from for-profit competitors by giving away a portion of its goods or services to the public (or to a charitable class, such as the poor or disabled) free of charge, and/or charging less than market rates. Lastly, an organization should have a diverse fundraising plan so it’s not relying entirely on fee-for-service income.